SME's lending and Islamic finance. Is it a “win-win” situation?

Information asymmetry is a common feature that hinders lending to small and medium enterprises (SMEs). In the last decade, the growth in Islamic banks lending to SMEs was overwhelming to the extent that it prompted practitioners to regard this as a “win-win” situation. Unlike a conventional bank that mainly resorts to relationship banking to SMEs, an Islamic bank uses a Murabaha contract that creates a “collateral-by-contract” to the borrower. Such distinct lending approaches by the two types of banks have an implication on banks' cost curves that arise from differences in monitoring cost. In this article, we develop a two-stage competition model to investigate the growth in SMEs lending by Islamic banks. In our theoretical model Islamic and conventional banks compete with prices at the first stage (Bertrand framework) and with loan output at the second stage (Cournot framework). Our results reveal that in price competition an Islamic bank will gain market share initially due to its differentiated product. However, in the second stage, the amount of lending to SMEs by Islamic banks decreases due to market share competition.